Question

Suppose that government spending makes private firms more productive; for example, government spending on roads and bridges lowers the cost of transportation. This means that there are now two effects of government spending, the first being the effects discussed in this chapter of an increase in G and the second being similar to the effects of an increase in the nation’s capital stock K.

(a) Show that an increase in government spending that is productive in this fashion could increase welfare for the representative consumer.

(b) Show that the equilibrium effects on consumption and hours worked for an increase in government spending of this type are ambiguous but that output increases. You must consider income and substitution effects to show this.

Answer 1

If government spending makes private firm more productive, then it is actually indirectly benefiting the end consumer as the cost of production will go down and so profits will go up but due t competition these swollen profits will be decreased as firms will be giving a substantial part of this extra benefit to the consumers by most probably lowering the price.

b) Output of the economy will increase as the lower cost of production will push firms to produce more, hence increasing the to tal outpot of the economy. Now the effect on consumption and hours worked can move in both the direction due to income and substitution effect depending upon the factor that which effect is stronger, As price will go down, people will have a feeling as if their incomes hasve increased so due to income effect they will move towards leisure and will want to work less but subtitution effect will work in opposite direction as people will need to work more to but more leisure. Consumption may increase or decrease because government spending will lower the prices on both normal & inferior goods. So its direction actually depends upon the goods basket of the consumers.